Interview

Not So Fast: Coping With Slow Growth

If the only way the average guy can put an oomph into his spending is by increasing debt, the economy lives a vulnerable life, says Jeremy Grantham. In a becalmed market, and with three-quarters of U.S. companies overpriced, he's hewing to trees and agricultural land—among other commodities.

Thank You

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As the Dow breached 13,000 last week, investors began to worry about a reversal in prices. So Barron's checked in with one of the great bubble-spotters to see if it was time to lose sleep.

It isn't, says Jeremy Grantham, the 73-year-old chief investment strategist of Boston money manager GMO, which manages $97 billion. Still, he says, the world faces myriad challenges, including the dilemma of slow growth.

The conversation with Grantham was too wide-ranging to include some of his best points. (For example, Grantham's solution to the slow-growth dilemma is worker education, including a free, government-sponsored, virtual-education system.) But for some well-founded views about market valuations, the Federal Reserve's missteps, and why you should care about Occupy Wall Street, keep reading.

Barron's: Should investors factor Occupy Wall Street into their assumptions?

If you get a really big skew in income, like in 1929 or today, it causes problems for the economy. If the only way the average guy can put an oomph into his spending is by increasing debt—the pattern since the '80s—the economy lives a vulnerable life, looking artificially strong, and then, with a hiccup, exaggeratedly weak.

"I'm very partial to land. It's the key to building up long-term wealth…I like stuff in the ground—metals, hydrocarbons, oil, even natural gas." -- Jeremy Grantham
Jason Grow for Barron's

If there was more income accumulation by the average consumer, the economy would have been healthier. It was once very fashionable to think that income skew contributed to the severity of the Great Depression. It went out of fashion because of the dominance of Milton Friedman, who said the only thing that matters is monetary policy.

The introduction of Asian labor at much lower cost made it easier for multinationals to make money and tougher for labor. Other countries have barely tilted, but the U.S. has tilted a lot, and has gone from one of the more equal societies to one where the inequality is fairly severe. That's created a big problem that economists should carry in the back of their minds.

But economists are given to fads.

How important a factor is it?

We began a period of seven lean years at the top of '07. The No. 1 factor is the global-debt overhang—I believe Australians, Brits and Canadians may even have had more consumer debt than we had.

So consumption will be a bit weaker, and developed-world gross domestic product will grow a bit more slowly. Then, the population of the same countries with the debt overhang are all aging. For a hundred years, U.S. GDP has grown 3.1% to 3.2%, coming back even after the Great Depression.

In the U.S., GDP came off-trend in 2000. Even before the '08 bust, we had already fallen about 12% below our long-term trend. So the days of 3.1% are gone, and, with lower population growth, we will simply have lower GDP growth.

The world has to adjust to the developed world's growing more slowly. And we've had a massive write-down in perceived wealth. The stock market went down, the housing market crashed, your assumptions on your 401(k) aren't coming through. So, the income-distribution issue isn't helping.

That makes my forecast of seven lean years look pretty solid. We're in no danger of growing faster than 2%. For most societies, creating a steady stream of jobs is the biggest single problem.

So, what kinds of disruptions do we need to see in the financial markets before they match up with the reality you forecast?

We do a seven-year forecast every month. On a seven-year forecast, global equities outside the U.S. are boring. They've been so nervous the last year that they mostly reflect the right degree of fear about European problems. Emerging markets and developed markets outside the U.S. are within nickels and dimes of fair value. This is very unusual. We are in the asset-allocation business, and we like to see horrific roller coasters: It gives us something to get our teeth into. What could be more boring than global equity markets at fair value?

About a quarter of the U.S. equity market—the high-quality, boring, great companies—is about fair price, too. The other three quarters are overpriced, and based on our numbers have a slight negative imputed return.

The bond market is a different story. It is manipulated mainly by the Fed to be artificially low, to move the stock market and have a benevolent effect on consumption. Operation Twist [involving the Fed's efforts to lower longer-term interest rates by shifting its portfolio toward lengthier maturities] is a dangerous long-term mistake.

You can push stocks up to get a wealth effect, but we live in a mean-reverting world, and they come back down again when you least need it. It's a pact with the devil. After-inflation and after-tax returns are going backwards, and who benefits? We know the financial system does.

In 2009 and so on, banks couldn't help but make money on the arbitrages involved from zero interest rates and their lending rates, at the expense of the people who would usually invest and use the income. If you could go back and pay pensioners the extra 3% interest, they would have spent all that in the economy.

Who benefits from the banking profits and the banking bonuses? Was there a great capital-spending surge? No. You took money away from people who would have spent it instantly, and gave it to people who have tended to sit on it.

What should the Fed do instead?

Stick to trying to keep a stable money supply that's adequate to the task, and not have growth as part of this mandate. If you want to stimulate the economy, you should use fiscal means. If there's an obvious oversupply of a certain kind of worker who will not be employed in the next eight months by corporations, then start a social project with a high return. My favorite example is insulating every attic in the Northeast.

Let's return to the U.S. equity market, of which three-quarters is overvalued, according to you.

It has been overstimulated forever. Interest rates are artificially low. If you look at the bond return, my God, you are being pushed into stocks. What a surprise, they are overpriced. In 1929, the market was 21 times earnings, and in 2000, 35. Long-term returns of the U.S. market, if you take out dividends, is 1.8% real. If the market ticked along at 1.8%, which is its fair value, no one would make any money. Goldman Sachs would be a quarter as big as it is. Big investment firms love big, hairy bull markets and delicious crashes so they can design and sell more instruments.

So is this "big, hairy bull market" a big, hairy bubble?

Absolutely not. Three-quarters of the market is what you might call routinely, substantially overpriced. While it is quite severe, it's nothing like 2000.

This is a business-as-usual overpriced market, and you'll get a zero return for seven years. So you should be able to get the return by going overseas or hiding in U.S. blue chips. If you have a fairly long horizon, like a seven-year horizon, you will do fine, and that's the only thing that matters.

Greece can do whatever it wants, create a nice little panic for three months, and you will have a great opportunity to take some of your reserves and put them in the market. In our traditional balanced account, we have a neutral weight in stocks. Bonds are terrible, but there are plenty of negatives around the global equity market, so they balance out.

Even if I would be very, very happy if the market came down 30% in the next six months, I don't think it will.

The first two years of the presidential cycle is the time you look around, see the world is concerned with deficits, and see that it's the time to tighten the system up a bit. But we'll have a little stimulus left to get re-elected. This is typically a year of gains, not sensational gains, but there aren't too many big bear markets.

Is the [30-year] long bond a bubble? Every bubble in our book has been driven by euphoria, and the thing about the long bond is, it's driven by the Fed and by nervousness. Why buy a long government bond at terrible rates? They are dangerously overpriced.

Every investment firm has great expertise. Ours is the recognition and understanding of the great asset-class bubbles. That's why we got 2000 and 2007 so right. We had huge confidence, and were able to stand against the crowd. We said "It's the end of the world, abandon ship," and everyone was just, you know, enjoying the sunshine. This time, we're not experts at these complicated sovereign, political situations. So we say, "Let's concentrate on the seven-year numbers, do our blocking and tackling."

In the past, you've been fond of hard assets and alternatives like timber.

Always been my favorite, but it doesn't make any sense unless you can think ahead 10 years or longer. The glorious thing about trees is it rains, the sun shines, they grow. If, when they are fully grown, the demand for lumber is weak, you don't cut, and they get bigger and more valuable. Come back in three years when the housing market has recovered, and you have an even bigger tree. Everything else has a negative-inventory cost.

Trees sit on land, and I'm very partial to land. It's the key to building up long-term wealth. I really worry about how we are going to feed 10 billion people, so I think agricultural land is also very interesting.

How do you play it?

You buy farms, which is messy. Some of the farmland in the Midwest has gone up too much too soon. But land is a complicated and varied investment vehicle, and it is all over the world. You can find decent investments today, and it probably isn't buying a prime farm in Iowa.

I can't really talk about it, because we are still in the process of researching these investments. We are still hiring people. We are building up the capability to do agriculture. Our forestry operation has done pretty well, with approximately $3 billion under management. We are going to see wonderful opportunities for people to take best practices and apply them somewhere else.

When I was born, there were two billion people on the planet, and now there are seven billion, and they eat more. And every time you eat meat, it requires five to 10 times the amount of grain. We used to have a new world to go to, but all the easy stuff has been done.

We have to farm more cleverly. When we get a really nice growing season, we will probably produce enough, and that will bring down land prices.

In 2008, there was a real scare in the agricultural index, and then we bounced back; then it crashed in 2009, and by 2011, the agricultural index was higher globally than in '08, which was so drastic that the Russian government overruled corporate contracts and forbade the export of Russian wheat.

I would bet you that within 20 years, global trade treats food, fertilizer and water-related issues differently from the rest of world trade, so people will say "I'll trade you my phosphate only if you give me some of your wheat." These are much more important issues than getting a fancier car.

What else strikes your fancy?

I like stuff in the ground—metals, hydrocarbons, oil, even natural gas. There are obviously powerful technical reasons depressing the price for natural gas. But it's the premium fuel. It burns cleaner and better than any other hydrocarbon, and it sells at the lowest ratio of heat equivalent to oil in 50 years. It is about 15% of the energy-equivalent oil price. It has sold at parity from time to time over the last 30 years. This is a dazzling opportunity.

We are running out of low-cost oil, out of cheap copper. All the miners with big reserves are interesting. Now, the prices aren't low; in '08, they shot up to multidecade highs. It used to be $16, and now it's $117. Something doesn't tally here. From the price, people think we are running out, and what happens when Europe and the U.S. get back into gear like in 2006, when the whole world was growing 5½%? The easy days of commodities are finished. We live in a new era where they are very volatile. But we are in an era of long-term price rises in pretty well every commodity.

Anything else?

The really bad news is that the 2% I thought we would have during the seven lean years is perhaps very close to what the long term will be, even after the seven years are up. It isn't clear to me that the developed world will grow faster than 2%, mainly because of the population, but also because we have caught up with each other.

Won't growth elsewhere help?

That may help us stay at 2%. What fraction of benefits accrues to workers in those countries? Look at how much the Chinese worker's lifestyle has improved over 30 years. But what benefits did everyone else have? We lost a lot of jobs here. Clearly, Australia and New Zealand benefit from supplying raw materials, but they are fairly small economies, and the benefit to Brazil is wildly overstated. Has Europe really benefited? Perhaps Germany, because it has specialized equipment and did wonderfully well in the capital-spending boom. But if you say Britain has gained enormously by exporting orange marmalade and pullovers to the Chinese, I'd say, "Probably not."